Needed: A New Growth Strategy for the Developing World

As most but not all of the East Asian economies struggle towards recovery from the devastating financial shocks of the last two years, it is more and more clear that the crises of 1997-98 signaled the end of the Asian miracle. That miracle, a burst of economic growth and rising prosperity unprecedented since the original industrial revolutions in North America and Europe more than a century ago, transformed the world’s political and economic structure. In a generation or less, a significant number of Asian economies moved from poverty to affluence, from technological backwardness to sophisticated users of cutting edge technologies, and from rural societies still tied to age-old agricultural and seasonal rhythms to urban societies fully participating in all the cultural storms and upheavals of the late twentieth century.

For twenty years, East Asia’s rapid growth transfixed the world. Wealth rose, inequality shrank, and East Asia’s share of world trade steadily grew. It seemed that Asia had discovered the secrets of King Midas, the ancient Near Eastern monarch who turned everything he touched to gold.

Many observers described the region’s economies as a flock of geese sweeping across the sky in a ‘V’-formation: Japan in the lead, with Taiwan, South Korea, Hong Kong and Singapore close behind. Farther back-but flying very fast-were Malaysia, Indonesia, Thailand, China and the Philippines. The other Asian economies, it was widely believed, would follow the trail blazed by Japan and other early developers, moving through light consumer assembly industries like textiles, toys and cheap electronics, ultimately to build steel, automobile and finally high tech and financial service industries.

Beyond East Asia, developing country governments, international financial and development institutions and western governments looked at East Asia’s success and sought to duplicate it elsewhere. Policy guidance from all these sources counseled developing countries to introduce reforms that would put them on the path toward export oriented growth and allow ever greater numbers of geese to follow Japan.

The collapse of the bubble economy

Unfortunately it now seems clear that export-oriented growth strategies, like the import substitution strategies popular two and three decades ago, do not work forever. The problems of Asia’s developing economies have many structural problems in common with the collapse of Japan’s bubble economy a decade ago, and point to deep flaws in what only recently looked like an answer to persistent problems of underdevelopment and poverty.

Most of the commentary on the economic problems of the export-oriented economies has centered on financial system issues: lack of transparency in lending, lack of effective oversight, government interference in credit allocation, failure to hedge properly against currency risk, mismatches between short-term debts to skittish foreigners and long-term loans to domestic borrowers, and failure to properly assess credit risks at a time of speculation and over-investment.

All of these things are true in varying degrees among the troubled economies, and financial sector overhauls will be necessary before the region’s prospects can decisively improve. Other developing countries would be wise to learn from Asia’s example and monitor their financial sectors carefully to prevent the excesses and errors that have so greatly exacerbated East Asia’s economic woes.

The end of the magic of export

These problems are complicated and solving them will be politically difficult and economically expensive-but with sufficient determination they can and will be solved. It is the non-financial obstacles to growth that cause the most concern to those interested in a return to rapid growth in Asia and economic progress in other developing countries. The chief problem here is that Asia’s basic economic pattern-high levels of domestic savings and investment combining with foreign investment (both direct and portfolio) poured into the creation of a manufacturing sector designed to produce goods for export to developed market economies-will not work as well in the future as it has in the recent past.

The villain is no longer western protectionism, though that continues to be a worry. The new problem is a combination of over capacity in the developing world and structural change in the developed market economies that looks set to reduce growth in demand for traded manufactured goods for decades to come.

Over capacity among producers of manufactured goods is a serious problem across a wide range of industries. State allocation of credit has greatly exacerbated the problem in many export-oriented economies; new, policy driven investments continued to be made in industries like automobiles and steel long after world wide over capacity problems had developed. State directed credit allocation succeeded in building industrial bases in many countries, but these countries now face difficult and painful reforms and restructuring given that their financial systems are now weak, while powerful political interests seek to defend an unsustainable status quo.

The problem with over capacity is more than a cyclical one. Fundamentally, export-oriented manufacturing in developing countries cannot expand at rates greater than overall growth in demand for such products. When only a handful of economies, most of them in small countries, were pursuing export oriented growth strategies, the size of foreign markets was not a constraint. That is no longer true. When Taiwan’s trade surplus with the United States peaked in 1987, it had reached $800 per capita-$800 of trade surplus for every man, woman and child on the island. For the United States, this trade deficit-totaling $16 billion, was manageable.

If mainland China were to achieve an $800 per capita trade surplus with the United States, however, the US trade deficit with China would reach $988 billion-$3,000 for every person in the United States. If Indonesia, Pakistan, India and Bangladesh follow the model, the US trade deficit with these countries would reach $2.1 trillion.

This, alas, is not possible and the implication is clear. Other countries cannot expect to achieve the same level of benefit from exports as the early adopters of export oriented growth strategies did. While exports will and should play important roles in development strategies in the future, successful development strategies in years to come will have to rely more on internal markets and on south-south trade.

The economic problem of excess capacity and therefore poor profitability for developing producers of manufactured goods is likely to be with us for the long term. It was once difficult to start up industrial production in developing countries. Now both the hardware and software aspects of industrial migration are well understood, and more and more countries are technically able to build export platforms.

Structural changes in the developed market economies will further limit the possibilities for exports of manufactured goods. Populations in most rich countries are stable or actually declining, reducing the prospects for economic growth overall and especially for growth in demand for manufactured goods. As these populations age, their consumption patterns change-away from traded manufactured goods like new cars, and new stereos and computers and towards non-traded services such as medical care.

Manufacturing is out, services are in

Moreover growth in the developed market economies has shifted decisively out of manufacturing and into services. To understand how this works, look at food consumption patterns in rich countries. Past a certain point, consumers don’t increase their consumption of food as incomes increase. What happens is that less of the food budget is spent on ingredients and more is spent on service: preparation. People eat out more and eat at fancier restaurants. As they choose more expensive foods-meat and fish instead of grain, exotic fruits and vegetables rather than staples-some additional income is possible for farmers. But most of the increase in spending goes for non-traded services: chefs, busboys, sommeliers, valet parking attendants and waiters.

As incomes continue to rise in advanced countries, consumers are likely to spend a relatively smaller proportion of their incomes on manufactured goods and other traded commodities, and more of their income on non-traded services. That is bad news for developing countries generally, and poses particular problems for countries whose growth strategies depend heavily on rapid increases in manufactured exports to the industrial market economies. We are probably at the beginning of a long term deterioration in the terms of trade for producers of manufactured goods comparable in some ways to the decline in terms of trade for commodity producers over the last century.

The governance challenge

At the same time, East Asian countries and other rapid developers face new and difficult governance problems. Economic development makes societies more complex and harder to govern well. An urban industrial society is harder to govern than a rural and agricultural one. Governments in East Asia and elsewhere today must cope with a myriad of difficult problems-land use, urban management, environmental protection, and so forth-which were less urgent and less complex only two decades ago.

Effective regulation of financial markets needs to be seen as part of this broader governance challenge. Financial markets in rapidly developing economies are more complicated than they used to be, they do more things, and they involve more complex transactions and different classes of risk. With respect to financial regulation as well as to other areas of the ‘new governance agenda’ of rapidly developing countries, the political obstacles for modernizers are deeply rooted and quite difficult to overcome. Current institutions and practices are deeply rooted in political power structures, and the resistance to change is determined and resourceful.

All this suggests that the developing exporters of manufactures face immense challenges. Faced with stiff competition, tight goods markets and complex governance issues, these countries need more than superficial reforms to get back on a sustainable growth path. Fortunately, the entrepreneurial drive, technical skills and pragmatic approach of East Asia’s rapidly developing countries have found creative solutions to equally difficult problems in the past and after a somewhat difficult and complex period of adjustment and reform, East Asia is likely to emerge once again as one of the most dynamic regions in the global economy.

Walter Russell Mead is Senior Fellow for U.S. Foreign Policy at the Council on Foreign Relations and directs a Ford Foundation project at the Council on the new global economy.